Yet another prescription for a far greater disaster

Mario Draghi’s Opiate of the Markets

By Luigi Zingales

From the standpoint of European stability, the Italian elections could not have delivered a worse outcome. Italy’s parliament is divided among three mutually incompatible political forces, with none strong enough to rule alone. Worse, one of these forces, which won 25% of the vote, is an anti-euro populist party, while another, a Euro-skeptic group led by former Prime Minister Silvio Berlusconi, received close to 30% support, giving anti-euro parties a clear majority.

Despite these scary results, the interest-rate spread for Italian government bonds relative to German bunds has increased by only 40 basis points since the election. In July 2012, when a pro-European, austerity-minded government was running the country, with the well-respected economist Mario Monti in charge, the spread reached 536 basis points. Today, with no government and little chance that a decent one will be formed soon, the spread sits at 314 points. So, are markets bullish about Italy, or have they lost their ability to assess risk?

A recent survey of international investors conducted by Morgan Stanley suggests that they are not bullish. Forty-six percent of the respondents said that the most likely outcome for Italy is an interim administration and new elections. And they regard this outcome as the worst-case scenario, one that implies a delay of any further economic measures, deep policy uncertainty, and the risk of an even less favorable electoral outcome.

The survey also clearly indicated why the interest-rate spread for Italian government bonds is not much wider: the perceived backstop provided by the European Central Bank. Although investors believe that the backstop is unlikely to be used, its mere presence dissuades them from betting against Italy. In other words, the “outright monetary transactions” (OMT) scheme announced by ECB President Mario Draghi last July has served as the proverbial “bazooka” – a gun so powerful that it does not need to be used.

Then-US Treasury Secretary Hank Paulson sought a bazooka during the 2008 financial crisis. He failed, because he believed that even a fake gun would work if it looked scary enough. Not falling for the trick, speculators repeatedly called his bluff. Draghi, with his famous pledge to do “whatever it takes” to ensure the euro’s survival, succeeded where Paulson did not. After all, he controls the monetary spigot.

But even Draghi’s bazooka is partly a bluff. Draghi designed it to relieve the ECB of the huge political responsibility of deciding when to save a country from default. For this reason, triggering the OMT mechanism requires the unanimous consent of eurozone governments. But, if the bazooka is needed, how likely is it to be fired before the German election in September? The Morgan Stanley survey did not ask this question, probably because everybody knows the answer: not likely at all.

Thus, markets remain calm because they expect the bazooka not to be needed. In that case, the fact that it cannot be triggered easily does not pose a significant problem. Its presence is enough to support a benign self-fulfilling prophecy. In other words, Draghi’s bazooka has anesthetized markets, impairing their ability to assess risk.

But as with all anesthetics, Draghi’s cannot and will not last forever. Either the underlying problem is fixed before the patient wakes up, or the pain will be devastating.

The investors surveyed by Morgan Stanley put the chance of a renewed crisis in Italy below 25%. I believe that it is higher than 50%. Even after Germany’s election, I am not sure that the government will be willing to support an Italian rescue program without asking for major guarantees concerning the objectives – and even the composition – of Italy’s ruling coalition.

Indeed, German Chancellor Angela Merkel will face a serious dilemma following her likely re-election. Without strict conditionality, she would risk shifting the domestic consensus in favor of Germany’s emerging Euro-skeptic mood. But, by insisting on such conditionality, she would trigger a huge political crisis in Europe. If the German government gets to decide who governs Italy, why should Italians bother voting? The eurozone will look like a German protectorate, rather than a voluntary union of sovereign countries. The political backlash would be enormous.

The only hope is that the eurozone makes strong progress toward establishing fiscal-redistribution mechanisms, such as European unemployment insurance, before Draghi’s anesthetic wears off. Otherwise, Europe will face a very rude awakening indeed.